Be Cautious – Avoid These 4 Stocks

by Tim Melvin | March 7, 2014 1:45 pm

Be Cautious – Avoid These 4 Stocks

We have heard a lot of smart people talk about the market lately, and they are all pointing to the need for caution.

Howard Marks of Oaktree is the latest to add his voice to the chorus, although he is a bit more positive than other. He believes stocks are on the high side of fairly valued, but also that there are more than enough bystanders to still jump on the bandwagon and push the market a bit higher.

In a recent conference call with investors, Marks’ main message was to move forward … cautiously. He also said in a recent interview: “Let’s think about a pendulum: It swings from too rich to too cheap, but it never swings halfway and stops. And it never swings halfway and goes back to where it came from.”

So what does caution look like for the individual investor? To me, it means stick with stocks that are safe and cheap and carry little risk of a permanent impairment of capital.

The safe and cheap undervalued stocks will go right up, but your chances of being destroyed when the party is over are diminished. Stocks like Richardson Electronics (RELL[1]) and Transworld Entertainment (TWMC[2]) have the ability to go up as the market bubbles higher but their asset value will act as sort of a floor in a decline.

That’s not the case with other high-flying stocks. There is no floor under stocks that trade at triple-digit multiples of profits and several times the value of the corporate assets. As an example, I’m a huge fan of Amazon (AMZN[3]) … as a consumer. Thanks to them, I never have to go to the dreaded shopping mall again. I’ve had two Amazon deliveries today alone and I’m a big Kindle fan as well.

For consumers, Amazon is a great company. However, AMZN stock trades for 600 times trailing earnings and 17 times its asset value. When the market does roll over (whenever that will be), there is no floor for AMZN stock.

The same case can be made for avoiding shares of Netflix (NFLX[4]). I love House of Cards, and my wife has several shows she likes to watch on the service. However, I struggle to understand how any company that has not cured cancer and perfected the solar-power flying car could possibly be worth 200 times earnings and 20 times book value.

More importantly, it is impossible to pinpoint at which NFLX stock is undervalued in a market correction. There is no margin of safety in the stock at all.

I am a social media user, but I still have not figured out how social media companies expect to make all these billions of dollars that are predicated. I have never clicked an ad on Facebook (FB[5]) or Twitter (TWTR[6]) and if did they started charging a fee I would probably stop using them.

When the market rolls over, whenever that happens, there is no margin of safety in social media stocks at the current price levels. Facebook trades at 100 times trailing earnings and Twitter shares fetch more than 250 times the profits analyst hope to fetch next year. These is simply no way to justify those multiples.

Being cautious means favoring those stocks with a floor and a margin of safety and avoiding those that are ridiculously priced in relation to earnings and assets. Everyone thinks they will be the one to get out before it all collapses.